Wednesday, February 9, 2022

Fed tightening is not a near-term threat

It's no secret that an aggressive tightening of monetary policy can be a real threat to the health of the economy. But even if the Fed surprises us with a 50 bps hike in short-term rates next month and even 4-5 more hikes by year end, policy will still be extremely accommodative. It's going to take a long time for Fed policy to become "tight," much less too tight. If this proves to be the case, then by inference inflation is very likely to be higher than the market expects, and for longer.

As I've noted in recent posts, there is one huge thing that is missing in all the buzz about inflation: the surging M2 money supply. And in virtually all the discussions about inflation, nearly everyone fails to mention that a widespread increase in many prices can only happen when there is a clear increase in the supply of money. If the Fed is doing its job, the supply of money should equal the demand for money. But if the Fed allows the supply of money to exceed the demand for money, then that's equivalent to boosting everyone's spending power: extra money is needed to drive a general increase in the supply of money. Without extra money in people's pockets, higher prices for energy (for example) mean that consumers have less money to spend on other things. But when energy, commodity, auto, home, and food prices rise significantly, that is virtual proof that there is an excess of money in the system. Which can only be remedied by the Fed adopting policies that increase the demand for money and reduce the supply of money.

What follows are some handy charts to use for reference as Fed policy progresses. 

Chart #1

Chart #1 is the best way to see whether monetary policy is tight or not. Notice the patterns that have repeated over the decades (with the exception of the sudden plunge in GDP two years ago): prior to every recession, the real Fed funds rate has surged to at least 3-4% and the slope of the yield curve has gone flat to negative. Those are classic hallmarks of tight money. Why? Because the Fed needs to raise real short-term rates to a level that discourages borrowing and encourages saving (i.e., to a level that boosts the demand for money). As real rates move higher, the demand for money becomes intense, liquidity becomes scarce, and marginal firms get squeezed. The bond market realizes that economic weakness is spreading and begins to anticipate a reduction in the real Fed funds rate in the future—so long term rates fall to or below the level of short-term rates. Currently, those two variables are not even close to suggesting that monetary policy is or is about to become tight. 

As a first-pass estimate, the Federal funds rate needs to at least equal the rate of inflation for monetary policy to become restrictive. If short-term rates are below the level of inflation, that by itself serves to weaken the demand for money (and encourage borrowing), thus allowing inflationary psychology to persist. If we don't see the growth of M2 start to decline soon (it's currently growing at double-digit rates), then you can expect to see inflation of at least 7% for some time to come. Unfortunately, the Fed only releases data on the money supply once a month; we will have to wait a few more weeks to see what happened in January.

Chart #2

Chart #2 shows the bond market's expectations for the future course of inflation (green line). Right now the market expects the CPI to average about 2.8% per year for the next 5 years. That's somewhat above the Fed's target, but only modestly. That means the market realizes inflation is going to be above average for the next few years, but the market is still convinced the Fed is not going to lose control of the situation. (The Fed defines "losing control" as "inflation expectations becoming unmoored.") I'm all for trusting the Fed, but I like to verify as well, and so far, they are failing on that score.

Chart #3

Chart #4

Small businesses far outnumber large businesses, so it's important to track what the owners of small businesses are thinking. That's shown in Chart #3, which measures the general level of optimism among small business owners. Optimism has fallen in recent years, but is only marginally lower than its long-term average. Things could be better, but they're not terrible yet. The economy is still quite likely to continue growing, since job openings are exceptionally plentiful, and there are still plenty of people willing to go back to work, as shown in Chart #4. Things could be a lot worse. 

Chart #5

Chart #5 shows the major problem cited by a majority of small businesses: prices are rising big-time. 

Chart #6

Over one-fourth of small businesses report paying their workers more (see Chart #6). Although the number dipped last month, it is still exceptionally high. As Chart #5 also shows, inflation today shares a lot in common with inflation in the late 1970s. 

Chart #7

It's rather impressive that a wide range of prices—industrial metals, agriculture prices, energy prices, home prices, etc) are up, and up significantly. In the past two years, many almost doubled in price. Chart #7 shows raw industrial commodity prices (red line) that have increase almost 50% since just before Covid hit. It's also interesting to note that in the past, commodity prices tended to move inversely to the strength of the dollar: a strong dollar depressed prices, while a weak dollar helped drive prices higher. These days that relationship seems to have reversed: the dollar is relatively strong, but prices are surging. I think this reflects a lot of excess money coupled with a general revival of the many activities (e.g., construction, new plant and equipment) that were put on hold during Covid. 

Chart #8

Chart #8 shows 2-yr swap spreads in the US and the Eurozone. Swap spreads are a highly liquid indicator of a) general liquidity conditions, b) the health of the economy, and c) the outlook for corporate profits. US swap spreads currently trade about smack in the middle of what might be considered a "normal" range. Eurozone swap spreads are a bit elevated, which probably reflects the fact that the outlook for the Eurozone economy is decidedly less optimistic than the US. No surprise there: the US stock market has outperformed the Eurozone stock market by some 85% in the past decade. A normal level of swap spreads here suggests abundant levels of liquidity and signal a healthy outlook for the economy and corporate profits.

Chart #9

Finally, Chart #9 shows 5-yr Credit Default Swap rates. Like swap spreads, these are highly liquid indicators of the outlook for corporate profits. Although spreads have risen a bit (out of possible concern that the Fed might tighten too much or too fast), they are still well within what might be considered a normal range. The Fed has yet to inflict any damage on the economy's fundamental indicators.


wkevinw said...

I like the treatment of real rates, such as in Chart 1, but the last time these rates were in the similar relationship, nominal 10 yr bonds were about 7.5%. I think the Fed has an arithmetic problem with negative real rates. However, I never thought we would get QE, and the purchase of the mortgages (which is probably illegal) by the Fed.

Anyway, somebody is very wrong. Many I respect are calling for a bond bull (wow, where would long rates go then....big negative), and many for a bear.

Right now, my bond market indicators are all on sell (every bond I might own is a sell). That might not be for long, but it's what is happening now.

Stocks- moderate bull (vs. strong bull for about the past 18 months.)

Good luck to all.

Benjamin Cole said...

Another great review by Scott Grannis.

I like to be optimistic, so I will say this: America's large private enterprises are as well-run as any on the planet. So, if profits can be made, they will make them. These are serious companies who hire lots of smart and hard-working people.

On the downside, the US government treatment of C19 has been as clunky as possible. One does have to be an anti-vaxxer or Trumper to wonder what anybody is thinking. (By the way, I feel the same way about the Afghanistan follies, also extraordinarily expensive).

The good news is (I hope) the War on C19 follies will end soon, just like Afghanistan. People see lockdowns don't work, stopping business does not work, masks don't work.

Whether vaccinations work better than natural immunity for the non-elderly is debatable.

Some wars you lose.

Adam said...

Thanks Scott as always.
Maybe I am the last in town, but just heard Joe Rogan with dr. Peter A. McCullough and with Oliver Stone. Have no words to comment this. For me Scott is a kind of JR of an eco stories.
Best to all.

JDonley said...

thanks Scott......for keeping it at a level even us non rocket scientists can understand. your charts are outstanding.

The Smoky Mountain Hiker said...

Thanks again Scott for providing these analyses. IMHO, this blog is the most insightful source of info on the economy. The charts provide an easy way to see the big picture.

Anyway, charts 1 and 5 seem to show current conditions that look a lot like the conditions in 1975 - which preceded the inflation boom of the late 70s and early 80s. Just an observation, which seems to feed the thought that inflation will be higher and stay longer as you've stated.

alpacino said...

Thanks for the info Scott! It baffles me that rates are still zero with 7.5% inflation. Fed members all saying they have to do something but they continue to print and not raise rates. The Bank of England even told people to not ask for raises. Seems to me like western central banks are lost. Cheers

Matthew Fry said...

Could it be that Central Bankers are actually comfortable with inflation staying elevated?

National debt is a drag-anchor on growth, but inflation erodes this in real terms. Comfortable with inflation running hot in order for better long term economic growth?

Benjamin Lemon said...

Thank you so much for all your guidance on inflation this year. Always love your blog and as I'm sure you know, you are reputedly widely read by the portfolio managers in my firm.

Only one suggestion: Please write a book on your personal experiences of inflation in Argentina combined with your observations of the US Economy. I'll buy multiple copies - I know a lot of people who need to read it!

With gratitude.

wkevinw said...

As usual, each political partisan is pointing at the other with basically 100% of the blame for the inflation.

Cullen Roche (PragCap) did a study where he subtracted out the inflation of categories that have supply chain constraints, and came to the conclusion that it's 70% demand side (fiscal and monetary policies: the old too much money...), and 30% supply side constraints (due to covid, "lock downs"/labor shortages"...)

Basically the MMT silliness flunked its first test in the way predicted: too much inflation.

That sounds about right to me.

Carl said...

"Basically the MMT silliness flunked its first test in the way predicted: too much inflation."
That makes sense. In previous wild inflation episodes, central banks literally printed money by discounting government debt paper directly. Now, since GFC and accelerating with the covid episode, the Central-bank-Treasury complex has created a regulatory and financial plumbing rules environment that has effectively forced commercial banks to take government debt on their balance sheets. In the end, for all this excess money that 'somebody' holds, there is still another 'somebody' (somehow through the consolidated system) who holds excess government debt paper. This apparently 'unseen' arrangement of quasi-mandated expansion of private banks' balance sheet means the MMT experiment has been tried and it's clearly failing on the inflation front. The transitory nature of the inflation will only be maintained if this unproductive expansion continues. Note: since December/January, it has not..

"National debt is a drag-anchor on growth, but inflation erodes this in real terms. Comfortable with inflation running hot in order for better long term economic growth?"
In order to find two comparable periods for such unprecedented levels of government debt vs underlying economic activity, you have to look at the UK after the Napoleonic wars and the US post WW2. Financial repression was part of the picture during the debt recovery but one cannot expect inflation based on government expenditures to carry the day. In both cases, it was productive growth that did just that (to be on the winner's side also helped).
Since December 2021, measures of money supply growth indicate zero or even slightly negative growth and we're halfway through Q1. It's reasonable to shortly expect the Atlanta Fed GDPNow to expect 0% or even negative nominal growth for the quarter. One can only guess what inflation numbers will register at once the growth trajectory becomes more visible. And the Fed hasn't even started to taper and the yield curve is flattening at record speed with minimal room left to raise short-term rates. Interesting times.

Scott Grannis said...

Carl: the Fed has not yet released any money supply data for the month of January. As of December's data, M2 was growing at a 12-13% annual rate. While the Atlanta Fed's GDP Now forecast is currently 0.7%, other sources are forecasting roughly 3% growth. Inflation is almost sure to remain high for the foreseeable future.

Carl said...

Hi Scott, this is interesting and revolves around data.
The main drivers of M2 are growth in bank loans and leases to private participants and loans to government (as well as through Fed excess reserve management although we know this is not true money growth).
All figures below annualized vs growth in M2.
For all loans and leases, from Dec29 to Feb11, loans and leases to private parties went from 10.763 (T) to 10,773 (T), so declining growth ++ now growing at 0.4% (annually).
For Treasury and Agency securities growing on bank balance sheets, end of Dec to end Jan, 4.564 (T) to 4.654 (T), so declining growth at 5.0% annualized.
Remember that this last component is MMT in disguise and future inflation developments there will determine if the US becomes a banana republic. My bet is that it won't, otherwise this means inflation during an economic slowdown and it's hard to see how this would benefit stocks but the timing of this potential development remains difficult to 'predict'.
For the last 15 years there's been quite a tight correlation between the expansion of commercial banks' balance sheet for government debt securities and 'money demand'. There has been some uncoupling lately (with covid heroic efforts) but money demand has remained flat for some time now despite a huge increase in MMT-type supply of government debt to banks.,M2V&scale=left,left&cosd=2007-03-01,2007-03-01&coed=2021-10-01,2021-10-01&line_color=%234572a7,%23aa4643&link_values=false,false&line_style=solid,solid&mark_type=none,none&mw=3,3&lw=2,2&ost=-99999,-99999&oet=99999,99999&mma=0,0&fml=a%2Fb,%281%2Fa%29%2F6&fq=Quarterly,Quarterly&fam=avg,avg&fgst=lin,lin&fgsnd=2020-02-01,2020-02-01&line_index=1,2&transformation=lin_lin,lin&vintage_date=2022-02-16_2022-02-16,2022-02-16&revision_date=2022-02-16_2022-02-16,2022-02-16&nd=1947-01-01_1947-01-01,1959-01-01

So, so far in 2022, money supply has been growing at 5.4% with a significant declining trend.

i would leave money supply growth at that in terms of inflationary (consumer, not asset) potential but the numbers you keep reporting in graphs include M2 growth from Fed open market operations including QE. You may have noticed that the Treasury lately has rebuilt a fairly large cash position at the Fed in the Treasury General Account (TGA). As you likely know also, every 'dollar' deposited in that account means (dollar-for-dollar) one less dollar in 'reserves' (excess or not). So despite ongoing residual QE and with neutral effects in the reverse repo window, since the beginning of 2022, the Fed has retired about 250B, meaning an annualized 10.7% decrease in M2. Including The Fed money activities, so far in 2022, money supply is declining at -5.3% and in a synchronized way, money supply growth has become negative also in the EU, UK and Japan.
i guess we'll have to see what is reported at the end of Q1 but if monetary and velocity trends persist growth and/or inflation will have to adjust on the other side of the equation.

Ataraxia said...

Need Scott's analysis of single/multi housing starts vs. household formation and demographics. etc. There are analysts on both sides of the overbuilding/underbuilding thesis.

Rents, OER are going to be a big part of the inflations picture and could turn into a larger crisis as many people are severely impacted by skyrocketing rent costs.

Scott Grannis said...

Carl, re M2 growth. I'll wait for the January M2 numbers which should come out next Thursday before I change my outlook for inflation. I would be surprised if they reflect your projections, which are based on a lot of things that are not directly included in M2.

GE Smith said...

Scott, are you watching the fiasco in Canada? You are based near San Fransisco and likely lean far left, but regardless of your political opinions -- seizing opposition bank accounts and locking people up who disagree with you is a VERY slippery slope. At least one of AOC's leftist gang is already warning about Trudeau's dictator powers causing blow back against government.

Sooner or later, the other party from yours will be in power, and once a bad legal precedent is set its impossible to put the toothpaste back in the tube.

Canadian government debt should be getting clipped big time. There have been past pushes to split Canada apart, but seizing bank accounts, revoking licenses, stealing dogs... these are not the actions of a stable government.

It doesn't matter if past Canadian governments honored their debts; past Canadian governments did not locking up opposition groups. Trudeau will have to go to prison or Canada will never be the same.

Should investors be cutting exposure to Canadian government bonds?

Scott Grannis said...

Canada is an example for all left-leaning politicians of what NOT to do. Once government become tyrannical the game is over. Freedom will always triumph.

BTW, I'm not based near San Francisco. I spend a good deal of my time in Orange County (just south of Los Angeles). I lived in Oakland and worked in San Francisco in the 70s, but I have no plans to return. The leftists have ruined a beautiful city, and they are ruining Los Angeles as well. Orange County is still a haven of sanity.

wkevinw said...

Fed tightening:

1. curve inversion- which exact curve must be inverted? Not sure, but this is the important variable: 1994- not too bad, 2008-bad.
2. Fed probably has poor quality price/inflation data caused by the usual bureaucratic pressures- wanting to support the bosses in a big organization. Poor real estate data was a significant cause of the 2008 problem.
3. If so (poor data choices), they have probably already caused the "policy error". They (minimum) need a between meeting rate hike and/or a 50bp hike; immediate 25bp hike is probably better.
4. Difference is probably between 20-40% stock market bear vs a 40-60% bear. They only have until end of March to make their moves.

If nothing the Fed does is forceful before end of March, we get a 40-60% stock market bear and another serious recession.

Carl said...

^Money supply growth will be certainly interesting to watch in 2022.
The Fed appears to be stuck in a tight corner and they may unconsciously hope for negative economic developments in order to put the Superman suite back on.
The financial structure in place makes it so that their market operations and influence are unlikely to produce positive and productive effects on the system in the long term but their actions have the potential to derail the system although they may try to postpone such as much as humanly possible.
In both Canada (which has become a tyranny?) and the US, central banks have never entered a tightening stage in a such a fragile (opinion) environment and yield curves have moved in tandem even if the US has been exporting some inflation as a result of the money flood that was even higher on your side of the border.
i may be wrong but this looks like a gathering storm. And Churchill was also called a crying wolf for a while. The Fed may look to appease and the crowd may be happy but.